Deconstructing ESG scores: How to invest with your own criteria

Abstract

Environmental, Social, and Governance (ESG) scores are the main tool for asset managers in designing and implementing ESG investment strategies. They amalgamate a broad range of fundamentally different factors, creating ambiguity for investors as to the signals of higher or lower ESG scores. We explore the feasibility and performance of more targeted investment strategies based on specific categories by deconstructing ESG scores into their granular components. First, we investigate the characteristics of the various categories underlying ESG scores. Not all types of ESG categories lend themselves to more targeted strategies, which is related to both limits to ESG data disclosure and the fundamental challenge of translating qualitative characteristics into quantitative measures. Second, we consider an investment scheme based on the exclusion of firms with the lowest scores in each category of interest. In most cases, this targeted strategy still allows investors to substantially improve the portfolio headline ESG score, with only a marginal impact on financial performance relative to a broad stock market benchmark. The exclusion results in regional and sectoral biases relative to the benchmark, which may be undesirable for some investors. We then implement a “best-in-class” strategy, based on excluding firms with the lowest category scores and reinvesting the proceeds in firms with the highest scores maintaining the same regional and sectoral composition. This approach reduces the tracking error of the portfolio and slightly improves its risk adjusted performance while still yielding a large gain in the headline ESG score.

Keywords: Sustainable investment, ESG ratings, ESG investing, Negative screening, Best-in-class screening

JEL Classification: G11, G24, M14, Q01